The Exchange Rate and the Reserve Bank's Role in the Foreign Exchange Market

Last updated: May 2019

Australia has a floating exchange rate. This page discusses the Australian dollar
exchange rate within the context of the Reserve Bank of Australia's monetary
policy framework and the role of the Reserve Bank in the foreign exchange market.

1. What is the Exchange Rate and Why is it Important?

The exchange rate is the price of one currency expressed in terms of another currency.
The two most common measures of the Australian dollar exchange rate are:

the bilateral exchange rate against the US dollar (AUD/USD). Trading of Australian
dollars on the foreign exchange market is, like most other currencies, predominantly
against the US dollar. The US dollar is also the main international medium
of exchange.

the trade-weighted index (TWI). The TWI is not a price in terms of a single foreign
currency, but a price in terms of a weighted average of a basket of currencies.
The TWI will therefore give a measure of whether the Australian dollar is
rising or falling on average against the currencies of Australia's trading
partners. This is often a better measure of general trends in the exchange
rate than any one bilateral exchange rate, such as that against the US dollar,
since the Australian dollar could be rising against the US dollar but falling
against other currencies. The TWI is also subject to less pronounced swings
in value compared with the bilateral exchange rate against the US dollar.

The composition of the TWI basket is determined by the relative shares of different
countries in Australia's trade, with the weights reviewed annually. The
current composition of the TWI is shown in Table 1.

Table 1: TWI Weights

As at 3 December 2018

Currency

Weights (%)

Chinese renminbi

27.7137

Japanese yen

10.9287

European euro

9.7397

United States dollar

9.6788

South Korean won

6.4751

Indian rupee

4.1447

New Zealand dollar

4.0210

Singapore dollar

3.9780

United Kingdom pound sterling

3.9507

Thai baht

3.5284

Malaysian ringgit

3.0481

Hong Kong dollar

2.6904

Indonesian rupiah

2.3643

New Taiwan dollar

2.2068

Vietnamese dong

1.8670

Canadian dollar

0.9742

Swiss franc

0.9437

United Arab Emirates dirham

0.8877

Papua New Guinea kina

0.8590

Sources: ABS; RBA

While the AUD/USD and the Australian dollar TWI often move together, they have diverged
at times (Graph 1). One notable divergence occurred during the Asian crisis
in 1997, when the AUD/USD exchange rate depreciated by much more than the TWI
because the Australian dollar appreciated against the currencies of most of
Australia's Asian trading partners.

Graph 1

There are many alternative exchange rate indices, which may be relevant for different
purposes. For instance, rather than using the conventional TWI based on (total)
trade weights, indices weighted by export shares or import shares separately
might be more appropriate in some instances. Alternatively, bilateral trade
weights may not provide the best basis for assessing changes in the home country's
competitiveness if there are other ‘third’ countries with which
the home country trades little, but with which it competes in terms of its
exports in international markets. In these instances, a ‘third-country’
export-weighted exchange rate index might be more appropriate. In other circumstances,
trade weights – which only include goods and services that are actually
traded – could be considered inadequate if they do not correspond to
countries' shares of production that could be traded (even if it is not)
and hence their influence on world prices. In these instances, a GDP-weighted
index may be considered preferable.

It is also worth noting that movements in broad exchange rate indices like the TWI
can sometimes mask important developments in individual bilateral exchange
rates or in groups of bilateral rates. For example, there has been a marked
divergence in trend movements of the Australian dollar against the currencies
of the G7 and against Asian currencies excluding Japan, which are the two main
groups of countries in the TWI basket. Over the post-float period, the Australian
dollar has depreciated against G7 currencies, but has appreciated significantly
against other Asian currencies (Graph 2).

2. Why Does Australia have a Floating Exchange Rate?

Exchange rate policy in Australia shifted through several regimes before the Australian
dollar was eventually floated in 1983 (Graph 3). From 1931, Australia's
currency was pegged to the UK pound, before it was changed to a peg against
the US dollar in 1971. For much of this period – from 1944 to the early
1970s – Australia's exchange rate peg operated as part of a global
system of pegged exchange rates, known as the Bretton Woods system. When the
Bretton Woods system broke down in the early 1970s, the major advanced economies
floated their exchange rates. However, Australia did not follow suit, in part
reflecting the fact that, at that time, Australia's financial sector was
relatively underdeveloped.

The Australian dollar did, however, become progressively more flexible from around
the mid 1970s. In 1974, a decision was made to peg the Australian dollar against
the TWI and in 1976 this peg was changed from a ‘hard’ peg to a
crawling peg. The crawling peg involved regular adjustments to the level of
the exchange rate, in contrast to the occasional discrete revaluations and
devaluations that had occurred under the previous regimes.

Graph 3

The Australian dollar eventually floated in 1983, for a number of reasons. First,
the fixed exchange rate regime made it difficult to control the money supply.
Like many other countries at that time, Australia targeted growth in the money
supply, under a policy known as ‘monetary targeting’. However,
under the fixed and crawling peg arrangements, the Reserve Bank was required
to meet all requests to exchange foreign currency for Australian dollars, or
vice versa, at the prevailing exchange rate. This meant that the supply of
Australian dollars (and therefore the domestic money supply) was affected by
changes in the demand for purchases and sales of Australian dollars, which
could arise from Australia's international trade and capital flows. While
the Reserve Bank could seek to offset these effects (through a process called
sterilisation), in practice, this was often difficult to achieve. This ultimately
meant that prior to the float there was significant volatility in domestic
monetary conditions (Graph 4).

Graph 4

Floating the exchange rate addressed this problem. It meant that one of the final
prerequisites for effective domestic monetary policy had been achieved (the
other, namely that the government fully finance any budget deficit in the market
at market interest rates, had been achieved in the early 1980s when the Australian
Government adopted a tender system for issuing bonds). While the ability to
gain greater control of domestic monetary conditions was well understood at
the time as one of the key benefits of floating the exchange rate, the decision
to float in late 1983 occurred largely as a result of speculative pressure
on the exchange rate. That is, in the lead-up to the float, there were very
large capital inflows coming into Australia from speculators betting on an
appreciation of the Australian dollar. This was not sustainable and the government
had the choice of either tightening capital controls or floating the exchange
rate. The latter was chosen as the more desirable course of action.

Consistent with obtaining better control over domestic monetary conditions, the choice
of exchange rate regime can also influence the way in which economies cope
with external shocks. Take for example, a sharp rise in the terms of trade
(the ratio of export prices to import prices), as experienced in Australia's
recent mining boom. The combination of a flexible exchange rate and independent
monetary policy led to a high exchange rate and high interest rates relative
to the rest of the world during that period, both of which played an important role in preserving
overall macroeconomic stability. This is in contrast to previous resources
booms, which typically ended with an episode of significant inflation.

In summary, the floating exchange rate regime that has been in place since 1983 is
widely accepted as having been beneficial for Australia. The floating exchange
rate has provided a buffer against external shocks – particularly shifts
in the terms of trade – allowing the economy to absorb them without generating
the large inflationary or deflationary pressures that tended to result under
the previous fixed exchange rate regimes. While discretionary changes were
made to the value of the Australian dollar under previous regimes in response
to developing pressures, it was extremely difficult to calibrate the adjustments
to provide an effective buffer against the shocks. The shift to a floating
exchange rate has therefore contributed to a reduction in output volatility
over the past two decades or so. Importantly, it has also enabled the Reserve
Bank to set monetary policy that is best suited to domestic conditions (rather
than needing to meet a certain target level for the exchange rate).

3. What Determines the Behaviour of the Exchange Rate?

One important determinant of a country's trade-weighted exchange rate over the
long run is whether it has a higher or lower inflation rate than its trading
partners. The theory of purchasing power parity (PPP) suggests that the exchange
rate between two countries will adjust to ensure that purchasing power is equalised
in both countries. If a country's inflation rate is persistently higher
than that of its trading partners, its trade-weighted exchange rate will tend
to depreciate to prevent a progressive loss of competitiveness over time. Graph
5 demonstrates this by showing the relationship between the nominal Australian
dollar TWI and the ratio of the Australian consumer price index (CPI) to the
average price level of Australia's trading partners. From the mid 1970s
through to the end of the 1980s, prices in Australia rose more quickly than
prices overseas. The TWI depreciated over the same period, but a large part
of this was doing no more than offsetting the cumulatively higher inflation
Australia was experiencing. In other words, much of what appears to have been
a potential gain in competitiveness due to the lower exchange rate was offset
by Australia's relatively poor performance on inflation.

Graph 5

Estimates of real exchange rates adjust for this difference in inflation rates. Between
the mid 1970s and the end of the 1980s, when Australia's CPI was rising
faster than that of its trading partners, the nominal TWI depreciated by about
50 per cent, whereas the real TWI depreciated by 30 per cent. While
still subject to considerable fluctuations, movements in real exchange rates
provide a better guide to changes in competitiveness than movements in nominal
exchange rates. A pure purchasing power parity theory is limited to the extent
that it does not capture structural factors affecting the economy, which have
arguably been important in Australia's case over the past decade or so.
In recognition of this, one extension of the pure purchasing power parity theory
is the Balassa-Samuelson model, which predicts that countries which experience
relatively rapid productivity growth in their tradable sectors will experience
real exchange rate appreciation (and vice versa). While cross-country productivity
differentials may have explained part of Australia's real exchange rate
depreciation in the mid to late 1980s, they are less able to explain the appreciation
of the Australian dollar over the past decade or so.

Historically, one of the strongest influences on the Australian dollar has been the
terms of trade. For example, a rise in the terms of trade as a result of an
increase in the prices of commodities (which are an important component of
Australia's exports) provides an expansionary impulse to the economy through
an increase in income. The increased demand for inputs from the export sector
also creates inflationary pressure. An appreciation of the exchange rate, together
with higher domestic interest rates, will counteract these influences to some
extent, thereby contributing to overall macroeconomic stability.

However, the strength of the relationship between the Australian dollar and the terms
of trade has varied over time (Graph 6). In the first 15 years of the floating
exchange rate, the relationship was on average one-for-one, but it has since
weakened. This weakening has implications for the robustness of models that
seek to estimate a ‘fair value’ for the Australian dollar (discussed
below). Nevertheless, changes in the terms of trade still play a dominant role
in explaining changes in Australia's real exchange rate.

Graph 6

Factors that affect capital transactions are a third major influence on the exchange rate,
although their importance has tended to vary over time. These factors include
relative rates of return on Australian dollar assets, changes in the relative risk
premium associated with investing in Australian dollar assets, and more broadly,
changes in investors' appetite for taking on risk. Anecdotally, there have been a
number of periods since the float when relative rates of return were seen as being
a major influence. One such episode occurred in the late 1980s, when Australian real
interest rates were much higher than those overseas and the exchange rate rose sharply.
The second was in the late 1990s, when Australian real interest rates fell below those
in the US and the exchange rate depreciated. The third was in the first half of the 2000s,
when Australian real interest rates were again notably higher than those in the major economies,
as the major economies experienced a downturn and monetary policy was eased in these countries.
Since mid 2009, relatively high real interest rates in Australia compared with the major economies
are again likely to have influenced the Australian dollar, although that effect has waned in recent years.

Historically, Australian interest rates have generally been higher than those in the major economies,
in part because Australian dollar assets have tended to embody a higher risk premium. Changes in the
size of the relative risk premium can influence the relative demand for Australian dollar assets
and therefore also have a direct effect on the exchange rate. For example, the relative risk premium
declined during the European debt crisis, which saw foreign demand for highly rated Australian government
debt increase. This was reflected in strong capital inflows to the Australian public sector in 2010 and 2011,
which are likely to have provided some support to the Australian dollar (though these inflows were somewhat
offset by outflows from the private sector over this period, Graph 7).

Graph 7

Empirical models of the exchange rate

While it is widely accepted that attempts to forecast exchange rates are fraught
with difficulty, even attempts to model historical movements in exchange rates
have met with mixed success. However, compared with some other currencies, efforts
to model the Australian dollar exchange rate in the post-float era have been
relatively successful in explaining medium-term movements in the currency,
reflecting its strong correlation with the terms of trade.

While it is possible to identify a number of determinants of the exchange rate, it
is important to note that their impact can vary over time. In particular, while
the terms of trade have displayed a strong correlation with the exchange rate in the
post-float era, there is evidence to suggest that this relationship has weakened over
the past 20 years (as discussed above). This relationship
was particularly weak in the late 1990s and early 2000s, when Australia's
terms of trade was rising but the nominal and real exchange rates both declined
substantially. Some part of this decline reflected the substantial appreciation
in the US dollar at the time, which was in turn attributable to investors shifting
their portfolios towards investment in ‘new economy’ technology
assets and away from the so-called ‘old economy’ assets prevalent
in Australia.

Variables other than the terms of trade have sometimes helped to explain movements
in the Australian dollar exchange rate. At times, real interest rate differentials
have had an important role; at other times, the stock of foreign liabilities,
the current account balance or economic growth differentials have been found
to have an influence. In part, the changing influence of some of these variables
reflects the varying focus of financial market participants.

4. The Exchange Rate and Monetary Policy

The exchange rate plays an important part in considerations of monetary policy in
all countries. However, the exchange rate has not served as a target or an
instrument of monetary policy in Australia since the 1980s – instead,
it is best viewed as part of the transmission mechanism for monetary policy.
More generally, the exchange rate serves to buffer the economy from external
shocks, such that monetary policy can be directed towards achieving domestic
price stability and growth.

Since the early 1990s, Australian monetary policy has been conducted under an inflation
targeting framework. Under inflation targeting, monetary policy no longer targets
any particular level of the exchange rate. Various measures suggest that exchange
rate volatility has been higher in the post-float period (Graph 4, above).
However, exchange rate flexibility, together with a number of other economic
reforms – including in product and labour markets as well as reforms
to the policy frameworks for both fiscal and monetary policy – has likely
contributed to a decline in output volatility over this period. In particular,
exchange rate fluctuations have played a particularly important role in smoothing
the influence of terms of trade shocks. Similar findings have been made for
other commodity producing countries.

Both through counterbalancing the influence of external shocks, and more directly,
through its influence on domestic incomes and therefore demand, the exchange
rate has been an important influence on inflation. Under the previous fixed
exchange rate regimes, the Australian economy ‘imported’ inflation
from the country (or countries) to which the exchange rate was pegged. However,
the floating of the exchange rate meant that changes in world prices no longer
had a direct effect on domestic prices: not only did it break the mechanical
link between domestic and foreign prices, but it meant that the Reserve Bank
was now able to implement independent monetary policy. Instead, under the floating
exchange rate regime, movements in the exchange rate have a direct influence
on inflation through changes in the price of tradable goods and services –
a process commonly referred to as ‘exchange rate pass-through’.
The extent of this influence has changed since the float, and since the introduction
of inflation targeting. In particular, exchange rate pass-through has become
more protracted in aggregate, but is faster and larger for manufactured goods,
which are often imported. The observed slowdown in aggregate exchange rate
pass-through is not unique to Australia, having been also found in the United
Kingdom and the United States, among others.

5. The Foreign Exchange Market

Foreign exchange turnover in Australia is currently around A$160 billion a day. According
to the most recent global survey of foreign exchange markets (conducted by
the Bank for International Settlements in April 2016) the Australian market
is the eighth largest in the world, although the two largest – the United
Kingdom and the United States – are much larger than the remainder. About
half of the turnover in the Australian foreign exchange market is against the
Australian dollar (Graph 8). The remaining half is largely made up of
trade in major currencies against the US dollar, although trade in less traditional
currencies has continued to expand.

Graph 8

Between 2000 and 2007, turnover in the Australian and global markets grew rapidly,
supported by increased cross-border investment and trade flows. Following the
onset of the global financial crisis, foreign exchange turnover fell in both
Australia and in other major markets, driven initially by a decline in foreign
exchange (FX) swaps turnover, which was in turn related to reduced cross-border
investment activity (FX swaps are transactions in which parties agree to exchange
two currencies on a specific date and to reverse the exchange at a later date,
and are commonly used to hedge foreign exchange exposures arising from cross-border
claims, Graph 9). Subsequently, the collapse in international trade in late
2008 also saw turnover in the spot market fall sharply. While between 2009
and early 2011, foreign exchange turnover in the Australian market recovered
in line with global markets, it dipped again in late 2011 amid heightened market
uncertainty related to the European sovereign debt crisis. More recently, foreign
exchange turnover in Australia has remained relatively stable.

Graph 9

In addition to the traditional market segment (comprising turnover in spot foreign exchange,
outright forward contracts and foreign exchange swaps), other ‘non-traditional’ foreign exchange
derivatives such as options and currency swaps are also traded in the Australian market.
The Australian market processes around A$5 billion of transactions in these non-traditional
products every day, covering a wide variety of products, ranging from very simple to more complex
designs. Foreign exchange derivatives, including both traditional and non-traditional products,
are an important tool for many Australian companies with foreign currency exposures, because they
can be used to provide protection against adverse exchange rate movements.

As well as trading in Australia, there is considerable turnover of the Australian
dollar in other markets. Global trade in the Australian dollar averaged around
US$350 billion per day in April 2016 (the date of the most recent global survey),
making it the fifth most traded currency in the world, and the AUD/USD the
fourth most traded currency pair (Graph 10). The size of the market indicates
that the exchange rate is being determined in a liquid, active and competitive
marketplace.

6. Why Does the Reserve Bank Intervene in the Foreign Exchange Market?

The Bank's approach to foreign exchange market intervention has evolved over
the past 30 years as the Australian foreign exchange market has matured. In
particular, intervention has become less frequent, as awareness of the benefits
of a freely floating exchange rate has grown. These benefits rely in part upon
market participants and end-users being able to effectively manage their exchange
rate risk, a process requiring access to well-developed foreign exchange markets.

In the period immediately following the float, the market was at an early stage of
development and the exchange rate was relatively volatile as a result. As market
participants were not always well-equipped to cope with this volatility, the
Bank sought to mitigate some of this volatility to lessen its effect on the
economy. This period has previously been described as the ‘testing and
smoothing’ phase of intervention.

But even before the end of the 1980s, the foreign exchange market had developed significantly,
and the need to moderate day-to-day volatility was much diminished. Accordingly,
the focus of intervention evolved towards responding to episodes where the
exchange rate was judged to have ‘overshot’ the level implied by
economic fundamentals and/or when speculative forces appeared to have been
dominating the market. This shift resulted in less frequent, but typically
larger, transactions than those undertaken in the 1980s (Graph 11).

Graph 11

As the foreign exchange market became increasingly sophisticated and market participants
became better equipped to manage volatility, particularly through hedging,
the threshold for what constituted an ‘overshooting’ in the exchange
rate became much higher: a moderate misalignment was no longer considered sufficient
to justify intervention.

More recently, intervention has been in response to episodes that could be characterised
by evidence of significant market disorder – that is, instances where
market functioning has been impaired to such a degree that it was clear that
the observed volatility was excessive – although the Bank continues to
retain the discretion to intervene to address gross misalignment of the exchange
rate. In particular, on certain days during August 2007 and October/November
2008, the Reserve Bank identified trading conditions that had become extremely
disorderly, with liquidity deteriorating rapidly in the spot market even though
there did not appear to be any new public information, resulting in sharp price
movements between trades. Accordingly, on each of these occasions, the Reserve
Bank's interventions were designed to improve liquidity in the market and
thereby limit disruptive price adjustments.

7. How Does the Reserve Bank Intervene in the Foreign Exchange Market?

When the Reserve Bank intervenes in the foreign exchange market, it creates demand
or supply for the Australian dollar by buying or selling Australian dollars
against another currency. The Reserve Bank almost always conducts its intervention
against the US dollar, owing to the fact that liquidity and turnover are greatest
in the Australian dollar/US dollar currency pair. The Reserve Bank has the
capacity to deal in foreign exchange markets around the world and in all time
zones. The Reserve Bank's foreign exchange intervention transactions to
date have been executed almost exclusively in the spot market. If the Reserve
Bank chooses to neutralise any resulting effects on domestic liquidity conditions,
foreign exchange intervention transactions can be ‘sterilised’
through offsetting transactions in the domestic money market or, as has been
typically the case, through the use of foreign exchange swaps.

In large part, the approach taken by the Bank will depend on the precise objective
of the intervention and, in particular, the type of signal the Bank wishes
to send to the market. By using its discretion in deciding when to transact,
the size of the transaction and how the transaction will be conducted, the
Reserve Bank is potentially able to elicit different responses from the foreign
exchange market. Generally speaking, transactions that are relatively large
in size and signalled clearly are expected to have the largest effect on market
conditions, with these effects further amplified if trading conditions are
relatively illiquid. This is in stark contrast to the routine foreign exchange
transactions undertaken by the RBA on behalf of the Government, where the express
intention is to have a minimal influence on the exchange rate.

Historically, the Reserve Bank has generally chosen to intervene by transacting in
the foreign exchange market in its own name, in order to inform participants
of its presence in the market. This ‘announcement effect’ can itself
have a significant impact on the exchange rate, as it conveys information to
the market about the Reserve Bank's views on the exchange rate from a policy
perspective. The intervention transactions are typically executed through the
electronic broker market, or through direct deals with banks. Intervention
in the broker market could involve the Reserve Bank placing a ‘bid’
or ‘offer’ (which means the market needs to move to that precise
level before a deal is struck) but, if it wishes to send a stronger signal,
the Reserve Bank would transact immediately in the market, either ‘giving
the bid’ or ‘paying the offer’ of the broker. Direct deals
with banks are similar, whereby the Reserve Bank would request a ‘two-way’
quote for a fixed amount and either ‘give the bank's bid’ or
‘pay the bank's offer’. The effects of direct transactions
with banks are realised over two stages. First, after receiving a direct quote
request from the Reserve Bank, banks will adjust their quotes as compensation
for holding the currency the Reserve Bank is trying to sell and for bearing
the potential risk that the Reserve Bank is simultaneously dealing with other
banks (who would also be adjusting their quotes). For example, if the Reserve
Bank wants to sell US dollars and purchase Australian dollars, banks will increase
their Australian dollar offer quotes. Second, after banks have traded with
the Reserve Bank, this can trigger additional price adjustments among market
makers in the spot foreign exchange market.

8. Has Intervention Been Effective?

It is inherently difficult to quantify the effect of intervention transactions on
the exchange rate for at least three key reasons:

Interventions usually take place when the exchange rate is moving in the opposite
direction to the expected effect of the intervention and it is virtually impossible
to know what would have happened to the exchange rate in the absence of the
intervention.

It may not always be appropriate to measure the success or failure of interventions
using a simple metric such as the daily exchange rate movement, nor may it
be feasible to develop alternatives.

Data which accurately identify the magnitude of genuine intervention transactions
have been scarce, with researchers often resorting to the use of imperfect
proxies.

These difficulties have led to the development of a number of different methods of
attempting to evaluate the effectiveness of intervention, three of which have
been employed by Reserve Bank staff in recent years to evaluate the effectiveness
of Reserve Bank intervention.

The first (Kearns and Rigobon, 2003), used the change in the Reserve Bank's intervention
policy in the early 1990s (when the Bank ceased to make very small interventions)
to identify the contemporaneous relationship between intervention and the exchange
rate. This study supported the description of Reserve Bank intervention as
‘leaning against the wind’ – that is, acting to slow or correct
excessive trends in the exchange rate. Intervention was found to have a significant
effect on the exchange rate, particularly on the day of intervention.

The second (Becker and Sinclair, 2004 and Andrew and Broadbent, 1994) used the ‘profits
test’ to evaluate the effectiveness of intervention, as advocated by
Friedman (1953). The application of the profits test relies on the central
bank acting as a stabilising long-term speculator. If the objective of the
central bank is to limit fluctuations in the exchange rate, this will tend
to involve the purchase of the local currency (sale of foreign currency) when
the exchange rate is relatively low, and the sale of the local currency (purchase
of foreign currency) when the exchange rate is high. If the central bank is
successful in ‘buying low’ and ‘selling high’, its
intervention should yield a profit. It follows from this that if a central
bank has been profitable in its intervention, it must have bought low and sold
high, therefore contributing to the stabilisation of the exchange rate. These
studies both found that the Reserve Bank's intervention activities have
been profitable, and therefore, stabilising.

The third study (Newman, Potter and Wright, 2011) presented the results of time series
econometrics using a unique dataset that specifically addressed problem (iii)
above. Notwithstanding the improved dataset, the results of this paper mainly
demonstrated the difficulties in drawing strong conclusions about the effectiveness
of interventions from time series analysis, owing to some inherent limitations
– in particular, problems (i) and (ii) above. Nevertheless, this study
does find some weak evidence that the Reserve Bank's interventions have
been effective.